In the midst of Washington’s ineptitude, it’s easy to lose sight of the bigger picture. Yes, tax law, fiscal prudence, and regulation do matter, but not as much as most people believe. There is still some short-term optimism on an eventual resolution to the fiscal cliff which is priced into the stocks, and some of that is coming out of the market today.
However, looking longer-term, the great contrarian play remains stocks. Investors across the board are vastly underweight stocks, and this can be seen in valuation discrepancies, such as stocks vs bonds. Granted, we don’t believe these low interest rates will be with us forever, but it’s still interesting to debate where stocks should be valued if rates are considered static. The attached Strategas report does the calculation for us. For us to return to a normal (in other words, average) historical relationship between stock valuations and interest rates, the S&P 500 would need to rise to 4,996 (currently, it’s 1,425). It would need to rise 15% from here just to get to being 2 standard deviations cheaper than normal. For statistics amateurs, 2 standard deviations is the bound beyond which the frequency is only about 2%.
It’s also interesting to note just how much cheaper stocks are (compared to bonds) than in the depths of the financial crisis of 2008 and 2009, when the ERP hit a peak of 400 bps (it’s 521 now). This totally jives with the amount of money that continues to flow out of stock mutual funds, even as the S&P has more than doubled from the low in March, 2009. This fact alone has kept millions of investors on the sidelines, but it should be remembered we’re still 10% below the 2007 highs.
With that, we wish you a very Merry Christmas!